California Needs to Stop Defined-Benefit Pensions

Governmentâ??s pension obligations are a looming disaster that can be eased by 401(k)-style retirement plans

The California Foundation for Fiscal Responsibility (CFFR) recently announced that it has filed two pension and retiree health-care reform initiatives with the California Attorney General’s office. The measures would alter the formulas used to calculate state and local government employee defined-benefit pensions for future employees, offering a lower “tier” of benefits to these employees and thus reducing pension costs to state and local agencies.

“With more than $200 billion in retirement debts and skyrocketing costs crowding out the investments we need in education, health care, transportation, public safety and the environment, it is time for a statewide solution to our retirement benefits crisis,” said CFFR president Marcia Fritz. “By requiring all new non-safety public employees at all levels of government to work until their Social Security retirement age for full benefits and ending the politicians’ raids and abuses of public pension funds, California public agencies can offer secure retirement benefits that are fair for taxpayers and their employees.”

The measure would only apply to new government employees because the courts have ruled that pension benefits are protected by the state constitution and cannot be reduced.

The only difference between the two versions of the measure is contained in a provision that would allow agencies to increase benefits for new workers. One would require a 3/4 vote of the Legislature to modify the benefit restrictions for state or University of California employees, and a 2/3 vote of the public to modify those of local government employees. The other would require a 2/3 vote of the Legislature to modify the benefit restrictions for state or University of California employees, and a simple majority vote of the public to modify those of local government employees. (See the language under subdivisions (c)(2)(A) and (c)(2)(B) on page 6 of the measures here and here, respectively.) According to the CFFR announcement, the organization intends to poll voters to determine which requirements they prefer, and thus which version will be pursued.

The state’s current pension system allows firefighters, Highway Patrol officers, and peace officers to retire as young as 50 years old and earn 3% of their final salaries for every year worked. Other state safety employees may retire at age 55 with a 2.5% multiplier and miscellaneous employees may retire at age 55 with a 2% multiplier or at age 63 with a 2.5% multiplier. Under the “New Public Employees Benefits Reform Act,” existing employees would continue to receive these benefits but those hired on or after the July 1, 2011, effective date would receive pension benefits as follows:

Police officers and firefighters could receive full benefits of 2.3% times the number of years worked with a minimum retirement age of 58.

Other public safety workers would receive benefits based on a 1.8% multiplier starting at age 60.

Miscellaneous employees would receive full benefits starting at the Social Security retirement age. Those workers that do not participate in the Social Security system would receive a 1.65% multiplier, and those that do would receive a 1.25% multiplier.

In no case would annual pension benefits exceed 75% of an employee’s base wage (calculated as the average of the employee’s highest earnings over a period of 3 consecutive years).

CFFR estimates that the measure would save more than $1 billion in the first year after implementation, and $500 billion over a 30-year period, as more employees are incorporated into the new lower benefit tiers.

While this would certainly represent a big improvement over the current system, it is still merely tinkering with the existing pension system when the system cries out for a complete overhaul. First, California has tried this before. In 1991, the state closed its existing pension plan (“Tier I”) to new miscellaneous (non-safety) state workers and required them to participate in a less generous plan (“Tier II”) in order to reduce state pension costs. But in 1999, the Legislature passed S.B. 400, which increased pensions by as much as 50%, reopened the Tier I plan to all employees, and retroactively increased state employees’ benefits. What is to prevent something like this from happening again if the CFFR measure passes?

The CFFR initiative does provide some measure of protection in the form of the requirement that voters approve changes to local government benefits and the supermajority requirement for the Legislature to increase benefits for state employees, but this may be of little comfort when one considers the power and influence of the government employees’ labor unions and the influence they have over the Legislature; in that 1999 pension increase vote, the measure was approved 70-7 in the Assembly and 39-0 in the Senate, so even the stricter supermajority requirements of the initiative would not have prevented those unwise benefit increases and unsustainable costs from going into effect.

The initiative would also preserve the unpredictable and volatile nature of the required government contributions to the system. This is an inherent feature of all defined-benefit pension systems. When the pension fund’s investments perform poorly, the state must make up the difference by making greater contributions to the system. This usually coincides with general economic downturn, meaning that just as the state is suffering from lower revenues, and thus more difficult budget decisions, it must make bigger contributions to the pension system at the time when it can least afford to do so.

Under a 401(k)-style defined-contribution plan, by contrast, the state contributes an agreed upon percentage of an employee’s salary (plus, perhaps, an additional matching contribution up to a certain level) to his or her retirement account each year and the employee, not the government, has the freedom and responsibility to manage his or her retirement investments. Thus, under a defined-contribution plan, there is no such thing as an unfunded liability. There is also no need to try to make economic projections and actuarial assumptions decades into the future concerning everything from the average expected annual return of pension fund investments, to the average inflation rate, to how long people will live, to how early people will retire, to the average annual salary increases for various classes of employees. These assumptions can too easily prove to be unrealistic or inaccurate, whether by nefarious attempts to fudge the numbers to make the pension system look more well-funded than it really is, by negligence, or simply due to unexpected economic events and outcomes.

The CFFR initiative deserves serious consideration for the fact that it would represent an improvement over the status quo, but if the state is to truly effectively tackle the structural problems and sustainability of its pension system, it must learn the lesson of the private sector and switch to a defined-contribution plan that offers compensation comparable to that received by private-sector workers.